The name Traralgon is thought to be a composite of Aboriginal words meaning river of little fishes, but linguistic analysis casts doubt on this. The explorer Strzelecki passed through this district in 1840. Edward Hobson occupied the Traralgon pastoral run from 1844. Sheep were grazed on the extensive plains along the river, while forest covered the rest of the country. A township was surveyed in 1859 but by 1861 there were still only a few buildings. A hotel catered to drovers and travellers and to miners bound for goldfields in the Great Dividing Range to the north.

From the 1870s selectors took up land on the pastoral runs, spreading south into the Strzelecki Ranges. The town did not grow much until the opening of the railway line from Melbourne in 1877. A number of sawmills were soon established, utilising the red gum timber for railway construction, local building and for sale in Melbourne. Access to markets for produce encouraged dairying, especially as more land was cleared. The Traralgon shire was proclaimed in 1879. Traralgon flourished after the opening of the rail line from Melbourne and an elegant post office and court house were constructed in the 1880s.

Australian Paper Manufacturers set up a mill, north-west of Traralgon in the late 1930s, by which time nearby Yallourn had been built from scratch to house workers for electricity production, based on the huge deposits of brown coal in the area. The privatisation of power generation saw decline in nearby Morwell and Moe, with Traralgon emerging as the dominant centre of the Latrobe Valley.